Question:
Brian Hotel is interesting a new hotel in Korea. The company estimates that would require an initial investment of $20 million. Brian Hotel expects that the hotel will produce positive cash flows of $3 million a year at the end of each of the next 20 years. The project's cost of capital is 13%.
What is the net present value?
While Brian expects the cash flows to be $3 million a year, it recognizes that the cash flows could, in fact, be much higher or lower, depending on whether the Korean government imposes a large hotel tax. One year from now, Brian will know whether the tax will be imposed. There is a 50% chance that the tax will be imposed, in which case the yearly cash flows will be only $2.2 million. At the same time, there is a 50% chance that the tax will not be imposed, in which case the yearly cash flows will be $3.8 million. Brian is deciding whether to proceed with the hotel today or to wait 1 year to find out whether the tax will be imposed. If Brian waits a year, the initial investment will remain at $20 million. Assume that all cash flows are discounted at 13%.
Using decision tree analysis, should Brian proceed with the project today or should it wait a year before deciding?